Question

Suppose you and other investors expect that inflation will be 4% next year, to rise to 5% during the following year and then to remain at 4.9% thereafter.  Further you expect that the real risk free rate of interest will remain at 2% and the maturity risk premium on treasury securities will rise from .2% for one year bonds.  Maturity risk premiums are expected to increase 0.2% for each year to maturity up to a limit of 1.0 percentage point on 5-year or longer term T-bonds.

What is the return on a 4-year bond? Write your answer as a percentage i.e. 8% is 8.

Answer 1

Year	1	2	3 & onwards
Inflation	8%	5%	3%
Real Risk Free rate= 2%
Maturity Risk Premium= 0.2% = > 1% ( Year 5)
Year	Infation rate	Average Infation rate
1	8%	8.00%
2	5%	6.50%
3	3%	5.33%
4	3%	4.75%
5	3%	4.40%
10	3%	4.17%
20	3%	4.00%
Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year T- Notes and T- Bonds
Year	Risk Free Interest ( A)	Average Infation rate (B)	Market Risk Premium( .2% Increase every year) ( C)	Interest rate ( A+B+C)
1	2%	8.00%	0.2%	10.20%
2	2%	6.50%	0.4%	8.90%
3	2%	5.33%	0.6%	7.93%
4	2%	4.75%	0.8%	7.55%
5	2%	4.40%	1.0%	7.40%
10	2%	4.17%	1.2%	7.37%
20	2%	4.00%	1.4%	7.40%